REITs Expected to Remain a Stable Investment in 2002

Analysts say the real estate securities are unlikely to perform as well as in 2001 but won't fluctuate wildly.

Shares of real estate investment trusts delivered bigger gains than the broader stock market for the second consecutive year in 2001, but REITs will be hard pressed to perform as well in 2002 as they did last year.

REIT stocks will remain a stable investment, analysts believe, but the recession is bound to catch up with an industry that relies on rents paid by tenants in the office and industrial buildings, shopping centers, apartment complexes and other commercial properties owned by REITs.

Indexes that track the "total return" of REITs--the combination of the dividend they pay and the net change in their stock price during the year--show that they outperformed both the Standard & Poor's 500 and the Nasdaq composite indexes in 2001.

The Bloomberg REIT index recorded a total return of 12.9% last year, while the S&P 500 fell 11.8% and Nasdaq dropped 20.8%.

Many REITs will continue to report earnings growth and will maintain or raise dividends this year, analysts forecast, but the rates of growth are likely to slow.

"We don't think REITs will be able to achieve the gains this year that they achieved last year," said analyst Ann Melnick of A.G. Edwards & Sons in St. Louis. "The fundamentals in the real estate industry are worse now than they were a year ago."

Melnick expects REITs to deliver high-single-digit-to-low-double-digit returns this year, comparable to the "modestly positive" gains in revenue and income projected by analyst Ross Smotrich of Bear, Stearns & Co. in New York.

Whether REITs can outshine the broader market again in 2002, analysts say, will depend more on how the overall economy performs than what happens in the real estate industry.

REIT shares could still outperform the broader market if the recession drags on and investors continue to favor stocks that produce income rather than riskier growth stocks. But if the economy begins to recover, experts believe more investors might switch to stocks with more potential to rise quickly in value.

"One of the concerns about REITs is that they did pretty well in 2001 because there was nowhere else for investors to go," Smotrich said. "As the economy starts to recover and show some momentum, some investors will surely go to other sectors."

If the economy were to recover quickly, according to Melnick of A.G. Edwards, REIT shares might suffer, even though the improving economy would boost the earnings of REITs.

A comparable situation occurred in the late 1990s, when fast-rising technology shares came into favor while REIT shares stalled, causing many REIT executives to complain that their stock prices did not reflect the financial success of their companies.

Regardless of whether the recession drags on or the economy snaps back, however, analysts agree that REIT stocks are not likely to fluctuate wildly.

"REITs will just plug along," as they usually do, said analyst Todd Stender of Crowell, Weedon & Co. in Los Angeles, expressing the widely held view that well-managed REITs will continue to deliver annualized dividend yields of 7% to 8%.

Melnick said many investors view REITs as a defensive investment that is not likely to plunge in value. "REITs have a sort of 'guaranteed' income stream because the tenants have leases of five to 20 years, depending on the sector," she said.

Those long-term leases also prevent REITs from profiting immediately when a recovery begins, Melnick said, because it takes a while before leases expire and REITs can raise the rents in response to increased demand.

If REITs in general are defensive investments, health-care REITs may be an even more defensive play.

"I think health-care REITs as a group are poised quite well to deal with a slower economy," said Kenneth B. Roath, chairman and chief executive of Newport Beach-based Health Care Property Investors, which owns hospitals and many other types of health-care-related properties. "Being government-reimbursed puts something of a cap on our growth, but it also puts a floor on the downside during a recession."

Nonetheless, Roath agrees with analysts who say investors ought to evaluate REITs on the basis of an individual company's performance.

"We are not saying that any one sector is going to outperform any other sector this year," Melnick said. She advises investors to look for companies with a history of earnings growth, a strong balance sheet and management that has shown it can improve financial results not just by acquiring property but also by implementing internal operating efficiencies.

REITs have fared well in part because they have continued to pay rising or stable dividends during a time of falling interest rates and thus are more attractive than money market accounts and bonds offering lower yields. But it's not clear how REITs would fare if interest rates rise.

"If interest rates go up, the spread between [bond yields] and REITs will narrow," Smotrich said, "especially since dividends will probably not grow as much this year because REIT earnings are not going to grow as fast."

On the other hand, Smotrich added, climbing rates could benefit REITs in some ways.

Rising rates sometimes slow the pace of home buying, which could benefit apartment REITs, he noted, and rising rates could draw some investors into REITs because they perceive real estate as a hedge against inflation.